05-29-2007, 11:48 PM
The Rising Rupee
<!--QuoteBegin-->QUOTE<!--QuoteEBegin-->Mercantilist monetary policies are popular in developing Asia, where central banks have plenty of money to intervene in foreign-exchange markets and keep their currencies cheap. But how long will the party last? At some point, intervention becomes too expensive and inflationary pressures too great.
That's the conundrum India is facing today, where waves of inbound foreign capital have led the central bank to abandon more than a decade's worth of heavy intervention in foreign-exchange markets to keep the rupee cheap. The rupee has risen by more than 8% since March, eliciting cries of pain from exporters and protests from the Commerce Ministry. But the move seems to have taken the edge off inflation, which has edged down to 5.4% at the beginning of this month, from a high of 6.5% in mid-March.
"We must learn to manage these inflows but we must not do anything that will restrict investment -- domestic and foreign, and private and public," Finance Minister Palaniappan Chidambaram told the Confederation of Indian Industry on Friday. That's exactly right -- though not always as easy a political matter.
Investment flows are an affirmation that foreigners judge India a good place to invest. They are a byproduct, too, of freer flows of trade and capital. India wouldn't be growing at 8 to 9% a year were it not for economic liberalization. But as the country opens up to trade and cracks open its capital account, it will be more exposed to global monetary policy.
Welcome to a world without stable exchange rates, in which central banks tussle with competing demands of keeping inflation under check while avoiding attacks on their currency. This year, the Reserve Bank of India found itself in a bind: It had to purchase the foreign currency to keep the rupee within its normal range, but it also had to sterilize those inflows' inflationary impact by issuing bonds. The costs of issuing the debt spiralled upwards, and in March, the RBI simply stepped back from the market, and the rupee shot up.
But will the RBI do what the Finance Minister suggests, and truly shed its old mercantilist ways? As soon as the rupee started to climb back toward its nine-year highs last week, the Reserve Bank started intervening again. Equally worrying, the central bank clamped down on real estate companies' ability to borrow abroad and repatriate the funds -- a major source of pressure on the rupee -- by setting limits on the bond yields they could offer.
Capital controls are distortionary, at best, and at worst, completely ineffective. Real estate companies aren't likely to stop raising money just because the RBI has discouraged them from selling bonds; they'll figure out other ways to do so. What's more, by capping the yields on bonds that real estate companies can raise, the RBI has tipped the scales in favor of larger companies at the expense of small and medium-size firms, which are the real drivers of India's economic growth.
New Delhi need only look to Thailand to see what broad capital controls can do to wreck a functioning economy. When the military-installed government -- pressured by the country's large exporting lobby -- clamped down on hard on incoming foreign-equity flows in December, the Bangkok Stock Exchange experienced a 15% one-day drop. In any case, the capital controls have done little to limit flows; the baht has continued to appreciate since December's action, and Bangkok has now lifted most of the controls.
India's exporters aren't happy with a rising rupee, but that's part of the price of doing business in an open economy. India could link its currency to the dollar, a la China, but that would mean abandoning its own monetary policy. It could, however, go on defense, and focus on what it can control: its domestic financial markets. It's past time India got serious about deregulating its banking sector, allowing futures and hedging markets to develop, and letting foreigners compete on an equal footing.
Unfortunately, those changes don't look likely under the current Congress-led government. <b>There may be an economist in the Prime Minister's seat, but it's Sonia Gandhi, president of the Congress Party, who's pulling the strings, and she's no friend to free markets. The closest this administration has gotten to financial-sector reform has been to crack open the capital account a little bit to let Indian investors put more money abroad, and to issue a few reports on what else needs to be done.</b>
New Delhi can't control how much money the U.S. Federal Reserve Bank releases into the global financial system. But it can control how efficiently it receives and distributes that money. The RBI may not be able to guide the rupee in the way it used to, but there are plenty of things it can do to bolster India's competitiveness.
<!--QuoteEnd--><!--QuoteEEnd-->
<!--QuoteBegin-->QUOTE<!--QuoteEBegin-->Mercantilist monetary policies are popular in developing Asia, where central banks have plenty of money to intervene in foreign-exchange markets and keep their currencies cheap. But how long will the party last? At some point, intervention becomes too expensive and inflationary pressures too great.
That's the conundrum India is facing today, where waves of inbound foreign capital have led the central bank to abandon more than a decade's worth of heavy intervention in foreign-exchange markets to keep the rupee cheap. The rupee has risen by more than 8% since March, eliciting cries of pain from exporters and protests from the Commerce Ministry. But the move seems to have taken the edge off inflation, which has edged down to 5.4% at the beginning of this month, from a high of 6.5% in mid-March.
"We must learn to manage these inflows but we must not do anything that will restrict investment -- domestic and foreign, and private and public," Finance Minister Palaniappan Chidambaram told the Confederation of Indian Industry on Friday. That's exactly right -- though not always as easy a political matter.
Investment flows are an affirmation that foreigners judge India a good place to invest. They are a byproduct, too, of freer flows of trade and capital. India wouldn't be growing at 8 to 9% a year were it not for economic liberalization. But as the country opens up to trade and cracks open its capital account, it will be more exposed to global monetary policy.
Welcome to a world without stable exchange rates, in which central banks tussle with competing demands of keeping inflation under check while avoiding attacks on their currency. This year, the Reserve Bank of India found itself in a bind: It had to purchase the foreign currency to keep the rupee within its normal range, but it also had to sterilize those inflows' inflationary impact by issuing bonds. The costs of issuing the debt spiralled upwards, and in March, the RBI simply stepped back from the market, and the rupee shot up.
But will the RBI do what the Finance Minister suggests, and truly shed its old mercantilist ways? As soon as the rupee started to climb back toward its nine-year highs last week, the Reserve Bank started intervening again. Equally worrying, the central bank clamped down on real estate companies' ability to borrow abroad and repatriate the funds -- a major source of pressure on the rupee -- by setting limits on the bond yields they could offer.
Capital controls are distortionary, at best, and at worst, completely ineffective. Real estate companies aren't likely to stop raising money just because the RBI has discouraged them from selling bonds; they'll figure out other ways to do so. What's more, by capping the yields on bonds that real estate companies can raise, the RBI has tipped the scales in favor of larger companies at the expense of small and medium-size firms, which are the real drivers of India's economic growth.
New Delhi need only look to Thailand to see what broad capital controls can do to wreck a functioning economy. When the military-installed government -- pressured by the country's large exporting lobby -- clamped down on hard on incoming foreign-equity flows in December, the Bangkok Stock Exchange experienced a 15% one-day drop. In any case, the capital controls have done little to limit flows; the baht has continued to appreciate since December's action, and Bangkok has now lifted most of the controls.
India's exporters aren't happy with a rising rupee, but that's part of the price of doing business in an open economy. India could link its currency to the dollar, a la China, but that would mean abandoning its own monetary policy. It could, however, go on defense, and focus on what it can control: its domestic financial markets. It's past time India got serious about deregulating its banking sector, allowing futures and hedging markets to develop, and letting foreigners compete on an equal footing.
Unfortunately, those changes don't look likely under the current Congress-led government. <b>There may be an economist in the Prime Minister's seat, but it's Sonia Gandhi, president of the Congress Party, who's pulling the strings, and she's no friend to free markets. The closest this administration has gotten to financial-sector reform has been to crack open the capital account a little bit to let Indian investors put more money abroad, and to issue a few reports on what else needs to be done.</b>
New Delhi can't control how much money the U.S. Federal Reserve Bank releases into the global financial system. But it can control how efficiently it receives and distributes that money. The RBI may not be able to guide the rupee in the way it used to, but there are plenty of things it can do to bolster India's competitiveness.
<!--QuoteEnd--><!--QuoteEEnd-->